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Europe is Getting Worse: Here's How to Protect Yourself

Every few months, the crisis in Europe rears its head, only to
fade back into the background once again. Unfortunately, signs are
emerging that Europe's troubles are deepening anew, so investors
need to tread cautiously with stocks until themarket digests these
newest concerns. Adding to the mix, another key trading partner --
halfway around the world -- is stumbling badly.

From south to north
For much of the past few years, economists have been talking about
thePIIGS (Portugal, Italy, Ireland, Greece and Spain). Though
Greece is in the midst of a crisis with no end in sight, the other
countries face ample stress as well. The biggest fear: The Greek
contagion spreads to the far larger economies of Italy and
Spain.

Yet many investors have been able to take solace in the relative
resilience of Northern European economies. Economic activity in
Scandinavia, the Netherlands and Germany has continued apace,
despite the storm clouds gathering to the south.

But now those clouds are overspreading Northern Europe as well.
In Germany, for example, economists have just lowered their
2013gross domestic product (
GDP
) forecast from 1.7% to a mere 0.8%. How important is the
Germaneconomy ? It accounts for 5.1% of globalGDP , according to
PriceWaterhouseCoopers. That's 50% larger than all of the PIIGS
combined -- excluding Italy. Including Italy, the PIIGS are about
6% of the world economy.

In France, economic growth is also expected to fall below 1% in
2013. But it could get worse: Economists at Societe Generale say
the French economy is slowing at such a rapid rate, it may not grow
at all next year.

Taken together, Germany and France collectively account for half
of all economic activity in the euro zone, or about 9% of the
global GDP. You can already see the continentwide malaise set in.
The pan-European Purchasing Manager'sIndex (PMI) slid from 46.1 in
September to 45.7 in October, the lowest level in three years,
according to economic research firm Markit. Any reading below 50
implies a contraction in economic activity. Surveys of business and
consumer confidence in Europe also hit three-year lows in
October.

Germany's PMI also slid to a two-month low, coming in at 47.7.
The country's contraction has clear roots: Orders from European
trading partners for Germany's manufactured goods fell 10%
sequentially in September, according to the German government. This
is the downside of a deeply interconnected economic bloc such as
Europe. Weakness in one part of Europe crimps demand from its
neighboring countries, which in turn see a slowing economy and need
fewer goods from the already-weak neighbor. It's a negative
feedback loop that can only be ended with some sort of jolt.
Trouble is, it's unclear where this jolt might come from, short of
massive government stimulus.

Although EuropeanCentral Bank President Mario Draghi continues
to pursue fiscal discipline while counseling against too much
austerity, he may soon have to speak of a much more aggressive game
plan. Until and unless that happens, the slowing European economies
will continue to weigh on stocks. Indeed we may soon be hearing
from major U.S. multinational firms about lowered 2013 sales
forecasts for their European divisions.

The Asian anchor
Much has been written about China's economic effect on the broader
Asian region. But don't forget about Japan, which is still the
third-largest economy in the world, representing more than 8% of
global GDP (compared to the United States' 22% share and China's
10.5% share). For a bit of context, the Japanese economy is larger
than the economies of Australia, India, South Korea and Indonesia
combined.

So the global economy is bound to feel the consequences of a
Japanese economy that is also under duress. On Thursday, Nov. 8,
the Japanese government announced that orders for machinery fell
4.3% in September from the prior month. At this point, the rest of
Asia has to watch out for this negative feedback loop that is
already besetting Europe.

Of additional concern: Japan's government debt has now become so
large that the country is increasingly likely to need to unload
foreignbond holdings in order to raise cash and pay its bills. It
may even seek out foreign investors for its ownbonds . This could
create a crowded field for government borrowers in 2013, altering
the current dynamic of ultra-low global interest rates.

Risks to Consider:
As an upside risk, these slowing economies may compel the
respective government to take action with new stimulus plans, which
can give a boost to global markets.

Action to Take -->
A slowdown across Europe and Asia won't necessarily force the U.S.
economy intorecession . But it's likely to create at least a
moderate drag on our own growth in 2013. So even as you focus on
the near-term challenges associated with the looming "fiscal
cliff," you need to also track events in Asia and Europe. Though
the current U.S. markets are starting to reveal deep bargains, we
will likely be hard-pressed to see any upside until the global
economic picture has been fully digested.

You canhedge against the effect of a slowing German economy on
U.S. companies by shorting stocks and exchange-traded funds (
ETFs
) focused on Europe. For example, the
iShares MSCI Germany IndexETF (NYSE:
EWG
)
looks increasingly vulnerable to the scenario outlined above, as it
continues to trade near its 14-month highs.

-- David Sterman

David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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